Chapter 15 Value, Leverage and Capital Structure © OnCourse Learning

Chapter 15 Learning Objectives  Understand the value of an equity investment in real estate  Understand how the use of debt can alter cash flows  Understand the concept of an optimal balance of debt and equity financing  Understand how more practical institutional matters affect the debt structure of real estate investments © OnCourse Learning 2

Valuation of Real Estate Investments © OnCourse Learning 3

Financial Leverage  Investor has two basic sources of financing: debt and equity  Financial leverage is the use of debt in financing  Positive leverage – the use of debt at a cost less than the return on the asset; increases the return on equity  Negative leverage – the use of debt at a cost greater than the return on the asset; reduces the return on equity  Neutral leverage – the debt cost is equal to asset return and return on equity is not affected © OnCourse Learning 4

Financial Leverage  The risk to the equity is increased by the use of financial leverage  Leverage allows the cash flows to be divided into two components: less risky and more risky  Value can be created if debt holders and equity holders have different risk-return preferences © OnCourse Learning 5

Financial Leverage  More risk-averse investor can invest in the lower-risk debt and less risk-averse investor can invest in riskier equity  Tax-deductibility of interest payments on debt make it advantageous  Federal government subsidizes the use of debt by providing tax relief © OnCourse Learning 6

Real Estate Cash Flow Structure – NOI Gross Rent (GR) – Vacancy (VAC) + Other Income (OI) = Effective Gross Income (EGI) – Operating Expenses (OE) = Net Operating Income (NOI) © OnCourse Learning 7

Real Estate Cash Flow Structure – ATCF Net Operating Income (NOI) – Mortgage Payment (MP) = Before-Tax Cash Flow (BTCF) – Tax Liability (Savings) (TXS) = After-Tax Cash Flow (ATCF) © OnCourse Learning 8

Taxes from Operations Net Operating Income (NOI) – Interest Expense (INT) – Depreciation (DEP) = Taxable Income (TI) x Investor’s Marginal Tax Rate (t) = Taxes (Savings) from operations (TXS) © OnCourse Learning 9

After-Tax Equity Reversion Estimated Selling Price (ESP) – Selling Expenses (SE) = Net Sales Price (NSP) – Unpaid Mortgage Balance (UMB) = Before-Tax Equity Reversion (BTER) – Total Taxes on Resale (TXR) = After-Tax Equity Reversion (ATER) © OnCourse Learning 10

Taxable Income from Resale Estimated Selling Price (ESP) – Selling Expenses (SE) = Amount Realized on Sale (AR) – Adjusted Basis (AB) = Total Gain from Sale (TG) – Depreciation Recovery (DR) = Capital Gain from Resale (CG) © OnCourse Learning 11

Taxes Due on Resale Depreciation Recovery (DR) x Depreciation Recovery Tax Rate (td) = Depreciation Recovery Tax (DRT) Capital Gain x Capital Gains Tax Rate (tg) = Capital Gains Tax (CGT) Depreciation Recovery Tax (DRT) + Capital Gains Tax (CGT) = Total Tax on Resale (TXR) © OnCourse Learning 12

Cash Flow Example – Assumptions  Investor purchasing a warehouse with a purchase price of $1,125,000; acquisition costs of $36,000  80% depreciable  33,600 leasable square feet; Initial rent of $12/sq. ft. per year and will increase 5 percent per year  Vacancy rate of 5% of gross rent per year; Operating Expenses are 40% of EGI  Mortgage is 75% LTV ratio, 20 years, monthly payments, 9% contract rate, 3% financing costs, 5% prepayment penalty for the first six years of mortgage life  Expected increase in value is 3.50% per year, 8% selling expenses  Holding period is 5 years  Investor is an active participant, is in a 28% marginal tax bracket, and requires an after-tax equity yield of 15%  Compute the ATCFs and the ATER for the holding period; NPV and the IRR © OnCourse Learning 13

Cash Flows from Operations Year GR403,200423,360444,528 - VAC 20,160 21,168 22,226 +OI =EGI383,040402,192422,302 - OE153,216160,877168,921 =NOI229,824241,315253,381 © OnCourse Learning 14

Cash Flows from Operations Year 4 5 GR466,754490,092 - VAC 23,338 24,505 +OI 0 0 =EGI443,416465,587 - OE177,366186,235 =NOI266,050279,352 © OnCourse Learning 15

Cash Flows from Operations Year NOI229,824241,315253,381 - MP 91,097 91,097 91,097 =BTCF138,727150,218162,284 - TXS 36,523 39,878 43,710 =ATCF102,204110,340118,574 © OnCourse Learning 16

Cash Flows from Operations Year 4 5 NOI266,050279,352 - MP 91,097128,520 =BTCF174,953150,832 - TXS 47,754 36,506 =ATCF127,199114,326 © OnCourse Learning 17

Income Taxes from Operations Year NOI229,824241,315253,381 - INT 75,296 73,814 72,193 - AFC 1,266 1,266 1,266 - DEP 22,823 23,815 23,815 =TI130,439142,420156,107 x t =TXS 36,523 39,878 43,710 © OnCourse Learning 18

Income Taxes from Operations Year 4 5 NOI266,050279,352 - INT 70,419105,902 - AFC 1,266 20,249 - DEP 23,815 22,823 =TI170,550130,378 x t =TXS 47,754 36,506 © OnCourse Learning 19

Cash Flow from Resale ESP1,336,147 - SE 106,891 =NSP1,229,256 - UMB 748,466 =BTER 480,790 - TXR 39,511 =ATER 441,279 © OnCourse Learning 20

Income Taxes from Resale ESP1,336,147 - SE 106,891 =AR1,229,256 - AB1,043,909 =TG 185,347 © OnCourse Learning 21

Income Taxes from Resale DR117,091 CG 68,256 x t d 0.25 x t g 0.15 =DRT 29,273=CGT 10,238 DRT 29,273 +CGT 10,238 =TXR 39,511 © OnCourse Learning 22

Cash Flow Summary Year ATCF ATER 0-342, , , , , ,326441,279 © OnCourse Learning 23

Net Present Value (NPV) © OnCourse Learning 24

Net Present Value (NPV)  Decision rule for NPV  Accept those independent projects that have positive or zero NPVs  Reject those independent projects that have negative NPVs © OnCourse Learning 25

Internal Rate of Return (IRR) © OnCourse Learning 26

Comparing NPV and IRR  In making a simple accept/reject decision, NPV and IRR cannot give conflicting recommendations  Mutually exclusive projects may lead to conflicting recommendations, usually resolved in favor of NPV  Multiple IRRs  Reinvestment rate assumption © OnCourse Learning 27

Cash Flow Analysis  15%:$256,668  IRR:35.50% © OnCourse Learning 28

Optimal Capital Structure  The proportions of debt and equity used in financing that maximize the value of the asset  NPV and IRR may be affected by the use of debt  Arguments that the use of debt cannot affect value: Modigliani and Miller  Reconciling MM argument with the use of debt  With income taxes the use of debt could increase the after- tax cash flows  Agency costs could increase the cost of debt © OnCourse Learning 29

Practical Considerations in the Use of Debt  Form of ownership – structure to avoid double taxation  Access to equity capital markets – limited; reliance on debt financing by small, non-institutional investors  Risk of the property – larger equity contribution for riskier investments  Bankruptcy costs – use of nonrecourse vs. recourse notes  Special tax regulations – the extent to which operating losses from real estate investment can be used to offset OI and the tax rate  Interest rate – lower rate, higher debt utilization 30 © OnCourse Learning

Real Estate Investing in the Real World  Acquisition costs must be written off over the depreciable life of the property  Financing costs must be written off over the life of the mortgage  Prepayment penalty is fully deductible in the year it is paid  A set-aside of funds (replacement reserve) is not a tax-deductible expense © OnCourse Learning 31